Three 1031 Related Party Rules CPAs Can Offer Guidance On
In an earlier post, we discussed some of the major issues involved when tax professionals counsel partnerships in 1031 exchanges.
As we saw, this can be a very delicate matter. Partnerships must handle their exchanges properly or else face severe negative consequences, including the dissolution of the exchange. Another area where CPAs, tax attorneys and other tax professionals can be of great service by providing correct counsel is the related party exchange. This situation must be handled with caution and precision.
In this article, we will go over three issues CPAs can provide guidance on. The first is simply the identification of a related party within the meaning of the code. Accountants need to be aware of what constitutes “relatedness” so they can identify potential related party exchanges. The second issue deals with the associated holding or ownership requirements, and the third involves the provision within the code pertaining to the underlying structure of the transaction.
Issue 1: The Identification of Relatedness
When a client inquires about an upcoming exchange, you should ask them about the possible relatedness of any involved party. A transaction will be classified as a “related party exchange” if either the buyer or seller has relatedness to the taxpayer. According to document 1031(f)(3), which provides a borrowed definition from Sections 267(b) and 707(b)(1) of the Tax Code, relatedness depends on whether the parties involved are individual or corporate persons.
In many ways, the applicable definition is more or less intuitive, but in others, it is not. For instance, family members are related parties, but not every degree of relatedness is encompassed by these sections. Cousins are excluded, as are uncles and aunts. Persons involved with trusts, i.e. grantors, fiduciaries and beneficiaries, also may be classified as related. It won’t be easy, but tax professionals should take the time to master their understanding of the term.
Issue 2: Holding Requirements of Related Party Exchanges
To prevent abusive tax avoidance, the law provides holding requirements on related party exchanges.
Under 1031(f)(1)(C), an exchange will fail if there is a disposition of property within two years of the last transfer. This applies to both the taxpayer and any related party involved in the exchange. In other words, if a related party purchases a relinquished property, they must hold it for two years. Likewise, if a related party sells a replacement property, the taxpayer must hold it for two years. If this requirement is not met, the taxpayer will recognize gain or loss on the underlying exchange. It is imperative that professionals counsel their clients on this requirement; otherwise, the transaction could be lost.
In addition to 1031(f)(1)(C), tax professionals must also be aware of 1031(f)(2). This paragraph provides a few exceptions to the two-year holding requirement.
Within this, subparagraph (C) is the trickiest. It provides that the holding requirement may be suspended if no disposition occurred, mostly for the purpose of avoiding tax. This is very subjective and will depend on the particular facts of a given case. The whole purpose of the rules is to prevent undesirable tax avoidance, which involves collusion to sidestep established regulations.
It’s very simple to see that this type of avoidance can happen more easily with related parties. But, if a taxpayer can show no disposition occurred simply to avoid taxes, the holding requirement may be suspended.
It should be noted the requirement and its accompanying qualifications are matters of frequent debate. This is true even among established professionals in the 1031 industry. There is wide dispute as to the level of risk involved in such situations. The IRS has issued various documents, but these have only contributed to the debates.
To minimize risk, for instance, some professionals recommend taxpayers buy from a related party in instances where that related party conducts an exchange. The key thing to remember is that, in determining what is permissible, the Tax Code and court opinions hold the most weight. What the IRS says has persuasive significance in some cases, but it does not make laws.
Issue 3: Subsection 1031(f)(4) & the Underlying Structure of the Transaction
This subparagraph provides that nonrecognition treatment will be denied to any exchange that is structured to avoid the purposes of Subsection 1031(f). Essentially, this is a restatement of the step transaction doctrine, but it is tailored specifically toward this subsection on related party exchanges. If a taxpayer takes steps specifically to “go around” or avoid the rules, the transaction may be collapsed. This is true even if it appears to comply with all of the provisions of Subsection 1031(f).
Let’s look at a possible case. For the purposes of Section 1031, the definition of related party includes a spouse. Suppose that a given taxpayer is married in a non-community property state and files separately.
In this hypothetical scenario, the taxpayer desires to buy and improve a property owned by his/her spouse. They also wish to re-sell this desired replacement property within two years to take advantage of favorable market conditions.
To accomplish this goal, the taxpayer divorces their spouse just one month before initiating the exchange. Then, after the replacement property is acquired, they remarry their partner just one month later. Technically, this transaction would not be regarded as a related party exchange because there was no relatedness. However, this would almost certainly fall within the purview of subparagraph 1031(f)(4). The taxpayer clearly structured the transaction to avoid the two-year holding requirement. This scenario would definitely violate the purposes of subsection 1031(f) and be denied nonrecognition upon legal scrutiny.
Related party exchanges are rather complex, and only a qualified tax attorney should offer guidance in any given case. However, the above information can help any tax professional identify instances where such counsel is needed and ensure they can better serve their clients.